The greatest beneficiaries of the QE-fuelled bull market of recent years have mostly been small and mid-caps, with many doubling in share price terms over a three year period. However, recent concerns over earnings growth has seen mid-caps in particular endure a choppier time of late.
FE data shows that the FTSE 250 has fallen 1.35 per cent over the past three months, whereas the FTSE 100 has risen 4.48 per cent.
Performance of indices over 3 months
Source: FE Analytics
Hall, who manages three Cartesian portfolios including the UK Enhanced Alpha fund, says a softer period of performance was inevitable, but thinks investors were too quick to sell and panicked in certain areas of the market.
“The recent set back in small and mid-caps have presented buying opportunities for some companies,” he said.
“The sell-off in parts of the market has been fairly indiscriminate and so has thrown up opportunities. This means there is much more stock dispersion in the market, and so there is a lot of opportunity for stock pickers.”
“It is not much of a surprise that we have had a short-term setback, because the market will always reconnect with fundamentals. However, the market is becoming much more discerning rather than being fairly ‘blanket-positive’ around small and mid-caps last year.”
Hall says before the sell-off, small and mid-caps had been through a period of being more popular than they have been for some time, leading him to take some money off the table at the beginning of 2014.
“At the tail end of last year some of the valuations seemed a bit stretched, as earnings growth [hadn’t come through],” he explained. “Buyers last year were buying in anticipation of a recovery in the UK economy.”
“However, we retain a bias to small and mid-caps for a variety of reasons. We believe that over time they offer better prospects of returns than their larger counterparts. They are less well covered by analysts and therefore have greater inefficiencies.”
“People may arrive at small and mid-caps because of an asset allocation decision; we are arriving at it because we think there is plenty of opportunity from the diverse companies that operate in these indices.”
The Cartesian UK Enhanced Alpha fund sits in the IMA UK All Companies sector, but has a strong small-to-mid cap bias. It is well ahead of its peers and its FTSE All Share benchmark since inception, but has lost money so far in 2014 on the back of the correction in his favoured area of the market.
Performance of fund, sector and benchmark
Source: FE Analytics
Hall points to financials as perhaps the most interesting small and mid-cap sector at the moment. He has recently added to his position in Paragon and bought Close Brothers.
“Paragon’s share price has come back in line with the mid cap market leaving it on a [price-to-earnings multiple] of 11 or 12 times, but it has just reported a good set of numbers,” he said.
“It is a company we have bought because we are very comfortable with the underlying growth and it is now on a better valuation point.”
He also has been buying into the construction sector, concentrating on infrastructure, and has bought Costain and the Atkins Group as a result.
“The UK has been in austerity measures for some time and that cannot continue forever. Infrastructure spending should increase,” Hall explained.
“These are the businesses that will benefit the most and they are at the right price, more importantly.”
Hall says he is optimistic generally on the outlook for the UK economy, noting improving metrics for consumer and business confidence, real wages, employment and investment.
However, he thinks the index-wide returns investors have seen in recent years are unlikely to be repeated.
“This should leave UK focused businesses in a better position. Undoubtedly the number of companies we have met over the past year have pointed to an improvement in the underlying trading,” he said.
“We are not outright bearish but we do anticipate a choppy market. We are at that point in the cycle when the shareholders who hold companies that disappoint don’t hang around to see what happens next. We have moved on from giving companies the benefit of the doubt.”